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How to Play the 4 Potential Economic Scenarios Over the Next 3 Years

Last week the Federal Reserve, made a very unusual announcement. It declared that it would could keep interest rates low as long as unemployment was above 6.5% and inflation was below 2.5%.

As of the end of November 2012, the unemployment rates was 7.7%, and inflation (as measured by the CPI) was 1.8%. This means that unemployment would need to drop by 1.2%, or inflation increase by 0.7%, for the Fed to change its policies. The last time unemployment was 6.5% was October 2008. However, CPI was above 2.6% as recently as March 2012.

US Federal Reserve Board Chairman Ben Bernanke testifies before the Senate Banking, Housing and Urban Affairs Committee July 17, 2012 on Capitol Hill in Washington, DC. Bernanke delivered the semiannual Monetary Policy Report to Congress and admitted Tuesday that US economic data had been 'disappointing' and that a further reduction in unemployment would likely be 'frustratingly slow.'AFP PHOTO/Karen BLEIER. (Image credit: AFP/Getty Images via @daylife)

What made this announcement unusual was its explicit targeting of an unemployment rate number, and tying that rate to future FED policy. While the FED has the mandate of maximizing employment while maintaining benign inflation, they have never directly tied their future actions to specific economic numbers. This is a big switch from making announcements which detailed the timing of future plans for interest rates. For example, the FED would typically say something like “We do not see a change in monetary policy for the next six months.”

Previously, the FED had indicated that it would be keeping US interest rates low through mid- 2015. Now, that date has become irrelevant. The Fed could keep rates much lower for 3, 5 or even 10 years if we continue to live in a slow-economic growth and low-inflation. Conversely if we see a large drop in unemployment and/or a big jump in inflation, we could see rates rise next year.

Will these new targets result in low interest rates for a longer or shorter period of time?

My understanding is that the FED was signalling to the market that it is willing to keep rates low well past June of 2015. In short, they want companies and investors to make decisions based on the FED continuing to “help” the economy as long as needed. On the other hand, by signalling their willingness ‘“pump up” the economy, the FED believes that it will create an economic environment where low interest rates are needed for less time.

By creating these explicit targets, the FED has limited its ability to act under its own discretion. If it doesn’t follow through with its policy, it will lose credibility and its words will have less impact on the market. Instead of trying figure out when the FED thinks it will raise rates, smart investors will now try to figure out when inflation and unemployment will break the targets set by the FED.

Here are 4 possible scenarios

Low-Inflation (below 2.5%) & High Unemployment (above 6.5%)For The Next 3 Years– In this case, interest rates will stay low into 2016 and perhaps beyond. Holders of longer term, high quality debt will benefit in this scenario.

Low Inflation & Low Unemployment For The Next Three years – In this case, interest rates will rise before 2016. While this is certainly bad for longer-term, high quality bond prices , riskier bond issues may benefit from the stronger economy (which is producing jobs and lowering unemployment). The impact on stock market is less clear. While a strong economy is good for stocks, the FED tightening monetary policy will offset some if not all of the impact.

High Inflation & High Unemployment For The Next Three Years – This is the worst case scenario which is referred to ask “Stagflation” (a stagnant economy with high inflation). This was last seen in the late 70s and early 80s. This would be the worst result and would indicate that the Federal Reserve went on the wrong policy course. The fix last time around was double digit interest rates for several years until inflation went down to a reasonable level. While stocks suffered greatly, bonds did even worse.

High Inflation & Low Unemployment For The Next 3 Years – In this case, interest rates would rise before 2016. However, the market would be extremely sensitive to the timing and types of actions by the FED. The FED would probably announce a slow, methodical multi-year plan to to tighten the money supply until inflation was under control.

What do I think is going to happen?

I agree with bond experts like Bill Gross, who think that inflation is going to rise faster than the Fed is expecting. This means that I give the highest probability to the last two scenarios. Whether we get stagflation or high inflation with low unemployment I am not sure. Either way bondholders who hold short duration bonds now will be the best positioned to capitalize when rates rise.

For more on how Bill Gross is advising investors to position themselves go here.

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